Tax Analysts Blog

Worker Misclassification Can Be Costly

Posted on Jun 18, 2014

A drywall contractor in Nashville, Tennessee, is facing a fine for misclassifying workers. At $300,000, the fine is the largest ever imposed by the Tennessee Department of Labor. Contractors in the Tennessee construction industry should take note. The department will likely be looking for others that are classifying workers as contractors rather than employees.

Worker misclassification has been an ongoing problem at the federal level for decades. Large amounts of potential tax revenue have gone unpaid because of the misclassification of workers as independent contractors rather than W-2 employees. If a worker is classified as an independent contractor, the employer files a Form 1099 at the end of the year and does not withhold taxes from the worker's paycheck. This means the employer avoids federal and state tax withholdings, payments for FICA taxes, the employer's matching share of Social Security and Medicare taxes, state and federal unemployment insurance premiums, state disability insurance premiums, workers' compensation costs, and other benefits.

Many states also require information returns for various types of non-payroll compensation and other income and may participate in the IRS Combined Federal/State Filing Program, which was designed to simplify the reporting of information returns to those states that participate. Under the program, the IRS will forward original and corrected information returns to participating states for approved filers.

There is a significant amount of information sharing, not only between the IRS and state departments of revenue but also among revenue departments and the Department of Labor and state departments of labor. For example, during a state tax audit, a company may be asked for W-2s and Forms 1099 to verify apportionment for payroll purposes. Forms 940 and 941 may also be requested to ensure the payroll factor has been picked up. Information from those forms may be shared with a labor department and result in another employment tax audit.

The wrong decision can be costly because in all later years, any workers who were reclassified as employees very likely must continue to be classified that way. Employers must consider the costs associated with other benefits for which a worker could be retroactively eligible if the worker is reclassified. In other words, if a worker is retroactively reclassified from independent contractor to employee, the now-employee may be entitled to retroactive benefits such as vacation and 401(k). And that’s not all. Because independent contractors are often paid a higher hourly rate than employees (because of the lack of benefits), the retroactive benefits could be based on that higher wage.

Given the focus on worker misclassification, if an employer chooses to use independent contractors, perhaps the best advice is to go in with eyes wide open. Knowledge of the law in this area is vital. Although worker classification is often a fact-based determination, there is published guidance that can be instructive when determining who is an employee and who is an independent contractor.

Read Comments (1)

Jay StarkmanJun 22, 2014

Tennessee DOL is very aggressive. This contractor may have Sec. 530 protection
at the federal level. TN statute provides that the state will honor a federal
finding. I had a case years ago where we won in TN district court on the 530
issue and were overruled by the appeals court which held that 530 doesn't
apply. Before the case was heard in district court, TN levied on my client's
bank account, collecting what it had assessed. Even if we had won on appeal,
we wondered whether we could ever get a refund of that levied tax. So much for
"tax friendly" Tennessee.

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